Thinking Fast and Slow to Beat the Market

Having trouble deciding whether you should worry more about the European banking crisis, the U.S. debt cliff or the slowdown in China? If so, you are not alone. But perhaps it is time to take a step back and consider how those worries are affecting your ability to think rationally.

The great expert on this question is the Nobel Prize winning psychologist, Daniel Kahneman. His best-selling book, Thinking, Fast and Slow, describes Mr. Kahneman’s intellectual journey in discovering how humans are hard-wired to make the wrong decisions much of the time.

Among the unhelpful mental biases that Mr. Kahneman discovered is our tendency to be overconfident about our ability to predict the future (or, for that matter, accurately explain the past). Our instinctive fear and greed, which were useful in a much earlier stage of evolution, now interfere with our ability to analyze. We tend to think primarily about short-term results. And we focus far too much on recent experience, which we assume will continue. This so-called “recency bias” means that investors (including the pros) are excessively risk averse when stock markets have fallen, and overly optimistic when markets have risen.

This partially explains why, over long periods of time, and after fees, only a statistically insignificant percentage of investment managers are able to beat the stock market index. Mr. Kahneman goes so far as to conclude that the investment industry is “built on an illusion of skill.”

This implies that the best approach to stock investing is to buy a low-fee index fund or ETF. A leading advocate of buying index funds is Jack Bogle, the founder of Vanguard Funds. In The Little Book of Common Sense Investing, Mr. Bogle cites a number of studies supporting the view that active investing is a loser’s game. Most other objective students of the stock market agree. Even Warren Buffett has often said that the best solution for most investors is a low-cost index fund.

And yet it is also true that a small percentage of investors do beat the market over time. To take a simple example, studies have shown that anyone can beat a traditional stock market index (where companies are weighted by their market capitalization) simply by buying all the companies in the index and weighting them equally. This is because overvalued stocks will always be overweighted in traditional indexes.

We also know that Mr. Buffett has beaten the market index each decade over the past 50 years. In his amusing essay “The Super Investors of Graham-and-Doddsville,” Mr. Buffett says that everyone who worked for his mentor, Ben Graham, in the 1950s, and went on to form an investment firm, has significantly beaten the market averages after fees. As Mr. Buffett points out, these firms all followed Mr. Graham’s value-based investment approach.

So how do we reconcile the rarity of those who beat the market with the evidence that at least some people have been able to consistently outperform?

I believe it is precisely because of the behavioural shortcomings that Mr. Kahneman has identified that stock market inefficiencies exist. And these mispricings can be utilized by the small minority of investors who understand, and are able to resist, most of our mental biases.

Mr. Kahneman has some tips on how we can improve our thought processes. He points out that, when it comes to avoiding investment errors, organizations can fare better than individuals. Debate between two or more people forces a more balanced view of risks and opportunities. And organizations can impose procedures that must be followed. So, when evaluating a company, use a checklist, and make a point of discussing your investment ideas with a knowledgeable friend.

The key is to be able to identify irrational behaviour by others while minimizing the chance that your own behaviour is subject to the same biases. So, take a long- term view. Wait patiently for waves of fear and greed to misprice stocks. If you can train yourself to be, in Mr. Buffett’s words, “fearful when others are greedy, and greedy when others are fearful,” you will indeed outperform the market over time.